This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

November 16, 2012

ETFs & Taxes: A Deeper Look

Investor and advisors can benefit from understanding the advantages and downsides of exchange-traded funds and other products

More On Tax Planning

from The Advisor's Professional Library

Annuities: Estate Tax
The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.

Long Term Care Insurance: Premiums
While premiums for qualified long-term-care insurance may be deductible as medical expenses there are exceptions to this general rule. Learn how to avoid unnecessary tax liabilities.

As tax time nears, investors and advisors should review the different tax treatment—and potential advantages—of exchange traded products.

In addition to their reputation for transparency and low cost, many types of exchange traded products are also known for their tax efficiency, due mainly to their unique structure.

The Power of Tax Efficient Returns

The tax efficiency of exchange traded funds (ETFs), for example, enables many ETF strategies to outperform traditional open-end mutual funds that target the same market sectors—a difference that may exceed 50 basis points a year for investors in the top tax bracket (see table).

For ETF investors, this benefit is largely achieved by delaying recognition of most capital gains, which are recognized when investors sell out of the ETF.

Source: Morningstar as of 7.31.2012. Covers the period 7.31.2007 – 7.31.2012Assumes investor pays the top tax rates.

It's worth noting that the categories with more active mutual funds—Small Blend, Foreign Large Blend and Diversified Emerging Markets—usuually have the largest difference in tax cost between the average fund and the largest ETF in the category.

The other stock category—Large Blend—typically sees lower tax costs from the ETFs than from the average fund, but less dramatically than the more-active stock categories. Note also that stock ETFs do still have some returns lost to taxes, largely due to taxes on dividends paid out by these funds.

Categories and designation of ‘Average Mutual Fund’ and ‘Largest ETF’ are based on Morningstar’s assessment. There are other Morningstar fund and ETF categories that may have provided a less favorable result over the time period specified.

* The tax-efficiency for ETFs primarily refers to lower capital gains distributions. This has little impact on fixed income funds, where most of the tax cost comes from interest payments. Since the market environment over the past five years has been fairly flat or negative for most of these categories, there have been relatively few capital gains distributions overall, which means that most of the tax cost in stock funds has been due to dividends. Since ETFs don’t have an advantage on dividend taxes, the differences in tax costs between funds and ETFs have been small. During periods where funds have realized more capital gains, however, ETFs have had much larger advantages, especially in the more actively traded categories of emerging market and US small cap stocks.

When an investor redeems shares in a mutual fund, the portfolio manager must often sell underlying positions to raise cash, potentially realizing capital gains that would be distributed to all shareholders. By contrast, purchases and redemptions of shares of an ETF are done by large institutional investors called Authorized Participants. These Authorized Participants purchase and redeem shares in large blocks of shares, called “creation units.”

Purchases and redemptions of creation units are done in-kind, which means that the Authorized Participant contributes a basket of securities with a value equivalent to 50,000 shares or 100,000 shares of the ETF. The Authorized Participant then takes the ETF shares that have been created and trades them on a securities exchange, where individual investors can access them.

In-kind purchases and redemption enable a more tax-efficient means of managing an ETF portfolio since redemption requests from Authorized Participants can be honored by returning them the lowest-cost tax lots of the securities in the ETF’s portfolio. By being able to redeem in this way, the ETF avoids the build-up of capital gains at the portfolio level. This helps spare individual investors from the annual capital gains distributions that are prevalent among open-end mutual funds.

This key distinction allows ETFs to be more tax efficient than mutual funds. Therefore the after-tax results for these vehicles, particularly with respect to capital gains, can be quite different (though it is important to note that investors in ETFs and other exchange traded products must pay tax on distributed dividends and interest).

Different Transactions Create Different Tax Liability

While many exchange traded products may be more tax efficient than mutual funds, different types of products may create different kinds of transactions, and thus different kinds of tax liabilities. Passively-managed index ETFs generally buy or sell securities potentially resulting in a realized long or short capital gain, under one of two scenarios, both of which involve a change to the index tracked by the ETF.

The first event is a corporate action, such as a merger, acquisition, or a spinoff—e.g., if a stock in the index is taken over by a company that is not in the index, a market-weighted ETF would have to sell the shares of the acquired company; or if a company in the index spins off part of itself, a pro-rated portion of the stock may have to be sold.

The second event involves normal portfolio rebalancing. Any weighted index (e.g., market-cap or equal weight) needs to be rebalanced periodically as weightings within an index change. The ETF must then be rebalanced back to its desired weighting.

For actively-managed exchange traded products, the number of tax events can significantly increase, especially for products that rely on short-term derivative contracts (e.g., leveraged and short products). The values of the holdings are marked to market with investors paying taxes annually at ordinary rates on realized and unrealized gains. In addition, when considering specific asset exposure advisors need be mindful of differences among various exchange traded products: For example, commodity products that use off-shore special purpose vehicles to gain derivative exposure spin off ordinary income, rather than dividend income.

Commodity products that use structured notes (i.e., a form of debt instrument) generate capital gains and interest income, which are taxed at their respective rates. Grantor Trusts, by contrast, often hold actual hard commodity assets and do not use derivatives at all—they may be subject to special tax treatment when shares are sold.

Tax Management Strategies

In many cases, tax harvesting may be efficiently managed using exchange traded products like ETFs. An investor can sell a security that has lost value and replace it with an ETF with focused exposure to the same market segment, which should react in a similar way to market factors impacting that segment. Investors may also create tax advantages by avoiding year-end fund distributions.

These are typically comprised of capital gains whose value is embedded in a fund’s price before distribution. Selling before distribution, as well as buying for replacement purposes after distribution is made, should enable investors to retain more value.

In implementing such strategies, however, investors and advisors should consult a tax specialist to ensure replacement purchases satisfy the wash-sale rules. And investors must be sure that any fund they are temporarily selling out of is not closed to new investors—if it is, then they will not be able to buy it back, even after the wash-sale period expires.

Finally, when dealing with any exchange traded products, especially those that regularly spin-off significant income or capital gains, investors and advisors need to determine the most appropriate type of account to use (e.g., individual, tax-deferred, or after-tax accounts).

This decision should be based on an investor's current income needs, investment time horizon, and his or her marginal tax rate.

Tax Efficiency Should Be Part of the Decision

Exchange traded products are simple, convenient vehicles that have broadened access to a wide range of conventional and alternative assets. They are primarily valued for their transparency, cost, and ease of trading, but tax efficiency is an important part of the mix.

Understanding the differences between the different types of exchange traded products is essential to ensuring that each investment is optimal for asset exposure, tax consequences and total return.

-------------

William H. Belden III is a managing director and head of product development at Guggenheim Investments.

The information contained herein is for educational and illustrative purposes and should not be regarded as tax advice. While exchange traded products discussed may have some tax-efficient attributes, these product structures were not designed with tax benefits as an objective. If shares of an exchange traded product are sold at a price other than their purchase price, the transaction will typically represent a taxable event.

This information does not represent an offer to sell securities of any fund and it is not soliciting an offer to buy securities of Guggenheim Investments products. There can be no assurance that an exchange traded product will achieve its investment objective(s). There are risks involved with investing, including, but not limited to, investment risk, which is the possible loss of the entire principal amount you invest. There is a risk that the value of the securities held by an exchange traded product will fall due to general market and economic conditions, perceptions regarding the industries in which the issuers of securities held by the exchange traded product participate, or factors relating to specific companies in which the exchange traded product invests. Please read a prospectus before investing.

This material contains the opinions of the author but not necessarily those of Guggenheim Investments and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.